Charles Evans, President of the Federal Reserve Bank of Chicago, has a front-line view of what went wrong in supervision of bank lending in the commercial real estate sector. An excerpt from his April 15 speech:
"In June of 2007, only 1.8 percent of these loans held by depository institutions were noncurrent. By the end of 2010 this fraction had increased sixfold. For the riskier construction and land development sector, things were even worse, with 16 percent of loans noncurrent at the end of 2010 compared to only 1.4 percent in June 2007.
"What could forward-looking prudential regulation have done to mitigate this deterioration in the commercial real estate market? When I asked my supervisory staff this question, their answers were a bit discouraging. The consensus was that we needed to act very early, probably in 2004 or 2005. But this was two or three years before the problems in this sector became clear. Realistically, it would have been very difficult to argue in 2005 that it was necessary to rein in this lending. The banks would give very good arguments why their business was well controlled. They would stress that the CRE loans on their books would be securitized and sold off in short order. Furthermore, real estate prices were rising, delinquencies were almost nonexistent, and various hedges were implemented. I wish it weren’t so, but given such arguments, it takes extraordinary confidence to make a contrarian call and rein in a profitable line of business that at the time faces negligible difficulties. In summary, prudential supervision is critical but can be difficult to implement perfectly."
